Chapter 21 Thrift Operations Outline Background on Savings Institutions Ownership Regulation of Savings Institutions Sources and Uses of Funds Sources of Funds Uses of Funds Balance Sheet of Savings Institutions Interaction with Other Savings Institutions Participation in Financial Markets Valuation of a Savings Institution Factors That Affect Cash Flows Factors That Affect the Required Rate of Return Exposure to Risk Liquidity Risk Credit Risk Interest Rate Risk Management of Interest Rate Risk Adjustable-Rate Mortgages (ARMs) Interest Rate Futures Contracts Interest Rate Swaps Conclusions about Managing Interest Rate Risk Exposure of Savings Institutions to Crises Savings Institution Crisis in the Late 1980s Credit Crisis of 2008-2009 Reform in Response to the Credit Crisis Credit Unions Ownership of Credit Unions Advantages and Disadvantages of Credit Unions Deposit Insurance for Credit Unions Regulatory Assessment of Credit Unions Credit Union Sources of Funds Credit Union Uses of Funds Exposure of Credit Unions to Risk Key Concepts 1. Describe the savings institution’s main sources and uses of funds. 2. Compare the sources and uses of funds between savings institutions and banks to explain why the savings institution’s exposure to risk differs from that of banks (especially interest rate risk). 3. Explain the cause of the credit crisis in 2008-2009, and the solutions. 4. Explain the sources and uses of funds for credit unions. POINT/COUNTER-POINT: Can All Savings Institutions Avoid Failure? POINT: Yes. If savings institutions use conservative management by focusing on adjustable-rate mortgages with limited default risk, they can limit their risk and avoid failure. COUNTER-POINT: No. Some savings institutions will be crowded out of the market for high-quality adjustable-rate mortgages and will have to take some risk. There are too many savings institutions and some that have weaker management will inevitably fail. WHO IS CORRECT? Use InfoTrac or some other source search engine to learn more about this issue and then formulate your own opinion. ANSWER: When economic conditions are weak, mortgage loan defaults will occur. When interest rates rise, savings institutions that provide fixed-rate mortgage loans will be adversely affected. Savings institutions can limit their exposure, but then their return may not be sufficiently high to satisfy shareholders. Therefore, some savings institutions will likely fail during a weak economy or rising interest rates. Questions 1. SI Sources and Uses of Funds. Explain in general terms how savings institutions differ from commercial banks with respect to their sources of funds and uses of funds. Discuss each source of funds for savings institutions. Identify and discuss the main uses of funds for savings institutions. ANSWER: Savings institutions obtain a large portion of their funds from savings deposits, more so than large commercial banks. While savings institutions can offer NOW accounts, they cannot offer the traditional demand deposits. Savings institutions concentrate on mortgages as their main use of funds. This differs from commercial banks, which concentrate on commercial loans and some consumer loans. Commercial banks offer a relatively small amount of mortgage loans compared to savings institutions. The major sources of funds for savings institutions are as follows: 1. Deposits, which include passbook savings, retail CDs, and money market deposit accounts; 2. Borrowed funds, which come from either their district Federal Home Loan Bank for an extended length of time, the Federal Reserve discount window for very short-term loans, through repurchase agreements, and in the federal funds market; 3. Capital obtained by issuing stock and retaining earnings. The main uses of funds for savings institutions are: 1. Cash to satisfy reserve requirements enforced by the Federal Reserve System and to accommodate withdrawal requests of depositors; 2. Mortgages where the real estate represented serves as collateral to guard against default risk; 3. Mortgage-backed securities issued by other savings institutions that were in need of funds; 4. Investment securities like Treasury securities and corporate bonds that provide savings institutions with liquidity; 5. Consumer and commercial loans where consumer loans are typically for home improvements and education; the Garn-St Germain Act of 1982 allowed them to use up to 10 percent of their assets for commercial loans; 6. Other uses include providing temporary financing to other institutions through repurchase agreements, and the federal funds market. 2. Ownership of SIs. What are the alternative forms of ownership of a savings institution? ANSWER: Stock savings institutions are owned by shareholders, and mutual savings institutions are owned by depositors. 3. Regulation of SIs. What criteria are used by regulators to examine a thrift institution? ANSWER: Capital, asset quality, management ability, earnings potential, liquidity, and sensitivity to risk factors. 4. MMDAs. How did the creation of money market deposit accounts influence the savings institution’s overall cost of funds? ANSWER: Money market deposit accounts (MMDAs) increased a savings institution’s cost of funds, because some depositors switched their funds from savings accounts or NOW accounts to the higher yielding MMDAs. 5. Offering More Diversified Services. Discuss the entrance of savings institutions into consumer and commercial lending. What are the potential risks and rewards of this strategy? Discuss the conflict between diversification and specialization of savings institutions. ANSWER: Savings institutions that diversify their business may become less reliant on mortgage lending and therefore may be able to stabilize their earnings. However, by diversifying, they forgo their specialization in their area of expertise. There is a cost to learning other businesses, such as commercial lending. Yet, the costs may be worthwhile in the long run, as diversification of services may be a necessary goal for survival. Regulatory restrictions have been loosened, allowing savings institutions to offer commercial loans and consumer loans (although they still concentrate on mortgage lending). The potential risk to savings institutions that now provide such loans is that they improperly assess creditworthiness due to inexperience. However, if they can properly perform the credit evaluation and other procedures (such as loan documentation), they may reduce their risk, because these types of loans allow savings institutions to diversify their asset portfolios. 6. Liquidity and Credit Risk. Describe the liquidity and credit risk of savings institutions, and discuss how each is managed. ANSWER: Savings institutions experience liquidity risk since they commonly use short-term liabilities to finance long-term assets. They commonly increase their liabilities rather than reduce their assets in order to increase liquidity. Since mortgages represent their primary asset, they are the main reason for default risk. Insurance is available for the many types of mortgages issued. In addition, savings institutions perform credit analysis and geographically diversity their mortgage loans to guard against default risk. 7. ARMs. What is an adjustable-rate mortgage (ARM)? Discuss potential advantages such mortgages offer a savings institution. ANSWER: An adjustable rate mortgage has an interest rate that is tied to some market-determined rate such as the one-year T-bill rate. The ARM rates are periodically adjusted in accordance with the formula stated in the ARM contract. ARMs are advantageous for savings institutions because they are used as a strategy to reduce interest rate risk. They enable savings institutions to maintain a more stable margin between interest earnings and interest expenses. ARMs also reduce the adverse impact of rising interest rates. 8. Use of Financial Futures. Explain how savings institutions could use interest rate futures to reduce interest rate risk. ANSWER: Savings institutions can sell financial futures in order to hedge against interest rate risk. If interest rates rise, the futures position will generate a gain that can offset the likely reduction in a savings institution’s spread. 9. Use of Interest Rate Swaps. Explain how savings institutions could use interest rate swaps to reduce interest rate risk. Will savings institutions that use swaps perform better or worse than those that were unhedged during a period of declining interest rates? Explain. ANSWER: A savings institution can swap fixed payments in exchange for variable payments. If interest rates rise, variable inflow payments to the savings institution increase while the outflow payments remain fixed. Thus, the favorable effect of the swap will offset the unfavorable effect of higher interest rates on the savings institution’s cost of funds. If interest rates declined, savings institutions that used swaps would perform worse than savings institutions that were unhedged. The favorable effect on the spread could be offset by lower swap payments received during a period of declining interest rates. 10. Risk. Explain why many savings institutions experience financial problems at the same time. ANSWER: Many savings institutions have a similar composition of assets, such as long-term fixed rate mortgages. This causes them to have similar exposure to interest rate risk and credit risk, so they may be adversely affected at the same time if they do not use strategies to reduce their exposure. 11. Hedging Interest Rate Movements. If market interest rates were expected to decline over time, will a savings institution with rate-sensitive liabilities and a large amount of fixed-rate mortgages perform best by (a) using an interest rate swap, (b) selling financial futures, or (c) remaining unhedged? Explain. ANSWER: A savings institution would perform best by not hedging since it could benefit from lower interest rates. Its cost of funds would decline and its spread would increase. The hedging techniques can offset adverse effects during periods of rising interest rates but also offset favorable effects during periods of declining interest rates. 12. Exposure to Interest Rate Risk. The following table discloses the interest-rate sensitivity of two SIs (dollar amounts are in millions). Interest Sensitivity Period From From Within 1–5 5–10 Over 10 1 Year Years Years Years Lawrence S&L Interest-earning assets $ 8,000 $3,000 $7,000 $3,000 Interest-bearing liabilities 11,000 6,000 2,000 1,000 Manhattan S&L Interest-earning assets 1,000 1,000 4,000 3,000 Interest-bearing liabilities 2,000 2,000 1,000 1,000 Based on this information only, which institution’s stock price would likely be affected more by a given change in interest rates? Justify your opinion. ANSWER: Manhattan S&L would likely be affected more by a given change in interest rates because its interest-rate sensitive liability level differs from its interest-rate sensitive asset level to a greater degree (as a proportion to total assets) for each interest sensitivity period. This can be verified by measuring the ratio of assets to liabilities within each category. This answer may surprise some students, since the dollar value of the gap is sometimes larger for Lawrence S&L. However, the different sizes of the two S&Ls must be accounted for. 13. SI Crisis. What were some of the more obvious reasons for the SI crisis? ANSWER: Some obvious reasons are: (1) rising interest rates in the late 1980s, which reduced the spread between interest earned on loans and interest paid on deposits; (2) fraud by managers or executives of some S&Ls; and (3) illiquidity, resulting from withdrawals by depositors. 14. FIRREA. Explain how the Financial Institutions Reform, Recovery, and Enforcement Act (FIRREA) reduced the perceived risk of savings institutions. ANSWER: FIRREA prohibited investment by savings institutions into junk bonds. Second, it mandated an increase in capital requirements of savings institutions. Third, it helped to eliminate many of the troubled savings institutions. 15. Background on Credit Unions. Who are the owners of credit unions? Explain the tax status of credit unions and the reason for that status. Why are CUs typically smaller than commercial banks or savings institutions? ANSWER: CUs are technically owned by the depositors. CUs are not taxed because they are non-profit institutions. CUs are small because each CU is designed to accommodate a particular group or affiliation. 16. Sources of Credit Union Funds. Describe the main source of funds for credit unions. Why might the average cost of funds to credit unions be relatively stable even when market interest rates are volatile? ANSWER: The main sources of funds are (1) share deposits, with no specified maturity, and (2) share certificates, which specify a particular interest rate and maturity. The proportion of funds obtained through regular share deposits at CUs are relatively large. The rates offered on these accounts have remained somewhat stable while rates on share certificates move with the market. This allows CUs to obtain much of their funds at a relatively low and stable cost. 17. Regulation of Credit Unions. Who regulates CUs? What are the regulators’ powers? Where do credit unions obtain deposit insurance? ANSWER: CUs are regulated by the National Credit Union Administration (NCUA), which has the power to grant or revoke charters. It also examines the financial condition of CUs and supervises any liquidations or mergers. Most credit unions obtain insurance from the National Credit Union Share Insurance Fund. 18. Risk of Credit Unions. Explain how credit union exposure to liquidity risk differs from that of other financial institutions. Explain why credit unions are more insulated from interest rate risk than some other financial institutions. ANSWER: Credit unions must rely on members for future deposits. They cannot accept deposits from nonmembers and are therefore more limited than other depository institutions. This can limit their ability to resolve any illiquidity problems. Their interest rate risk of CUs is limited because they do not provide long-term loans with fixed rates. 19. Advantages and Disadvantages of Credit Unions. Identify some advantages of credit unions. Identify disadvantages of credit unions that relate to their common bond requirement. ANSWER: Possible answers are: 1. They offer attractive rates to members, as they are non-profit and not taxed. 2. Non-interest expenses are relatively low. 3. They have a small spread between loan and share deposit rates, which benefits savers and borrowers. A disadvantage is that the common bond requirement restricts a CU from growing beyond the potential size of that particular affiliation. It also limits the CUs ability to diversify among its balance sheet accounts and also geographically. 20. Impact of Credit Crisis. Explain how the credit crisis in the 2008-2009 period affected some savings institutions. Compare the causes of the credit crisis to the causes of the savings institution crisis in the late 1980s. ANSWER: Some subprime lenders did not anticipate that market interest rates would rise, or that the higher mortgage payments resulting from the higher market interest rates would cause so many loan defaults. Even the subprime lenders that sold all the mortgages they created were adversely affected by the credit crisis, because once the economy weakened, the level of mortgage originations declined substantially. Both crises were caused by lenders that attempted to generate very high returns without recognizing the risk involved. 21. Impact of Interest Rates on an SI. Explain why savings institutions may benefit when interest rates fall. ANSWER: The assets (such as consumer loans and fixed-rate mortgage loans) of savings institutions commonly have fixed rates, so interest income does not adjust to interest rate movements until those assets reach maturity or are sold. Therefore, when interest rates fall, an SI’s cost of obtaining funds declines more than the decline in the interest earned on its loans and investments. 22. Impact of Economic Growth on an SI. How does high economic growth affect an SI? ANSWER: High economic growth results in less risk for an SI because its consumer loans, mortgage loans, and investments in debt securities are less likely to default. Interpreting Financial News Interpret the following statements made by Wall Street analysts and portfolio managers. a. “Deposit insurance can fueled a crisis because it allows weak SIs to grow.” Deposit insurance protected depositors, so that the protected depositors place deposits in risky SIs without worrying about how the SIs managed those funds. b. “Thrifts are no longer so sensitive to interest rate movements, even if their assets and liability compositions have not changed.” Thrifts now use derivatives such as interest rate swaps to hedge their exposure to interest rate risk. c. “Many SIs did not understand that higher returns from subprime mortgages must be weighed against risk.” SIs that provided subprime mortgages were betting that the economy would remain strong enough so that homeowners with questionable credit could make mortgage payments, but the SIs were wrong. Managing in Financial Markets Hedging Interest Rate Risk As a consultant to Boca Savings & Loan Association, you notice that a large portion of 15-year, fixed-rate mortgages are financed with funds from short-term deposits. You believe the yield curve is useful in indicating the market’s anticipation of future interest rates and that the yield curve is primarily determined by interest rate expectations. At the present time, Boca has not hedged its interest rate risk. Assume that a steep upward-sloping yield curve currently exists. a. Boca asks you to assess its exposure to interest rate risk. Describe how Boca will be affected by rising interest rates and by a decline in interest rates. Boca should be adversely affected by rising interest rates in the future; it should benefit from a decline in interest rates. b. Given the information about the yield curve, would you advise Boca to hedge its exposure to interest rate risk? Explain. Boca should hedge its exposure to interest rate risk, because interest rates are expected to increase according to the slope of the yield curve. If interest rates increase, Boca’s spread will decline, and Boca’s value will be adversely affected. c. Explain why your advice to Boca may possibly backfire. Your advice to Boca could backfire if interest rates decline rather than rise. This could happen either because the yield curve was based on forces other than interest rate expectations by the market, or because the expectations by the market were incorrect. Consequently, a hedge will limit the potential gains that may have resulted if Boca’s exposure to interest rate risk was not hedged. Flow of Funds Exercise Market Participation by Savings Institutions Rimsa Savings is a savings institution that provided Carson Company with a mortgage for its office building. Rimsa recently offered to refinance the mortgage if Carson Company would prefer a fixed-rate loan rather than an adjustable-rate loan. Explain the interaction between Carson Company and Rimsa Savings. Carson Company benefits from Rimsa because it has access to funds that it needs to pay for its office building. Rimsa obtains funds from depositors and benefits from channeling these funds to Carson because it charges a higher interest rate on the loan than it pays on the deposits. The spread also covers non-interest expenses incurred. b. Why is Rimsa willing to allow Carson Company to transfer its interest rate risk to Rimsa? [Recall that there is an upward-sloping yield curve.] Rimsa offers to provide a fixed-rate loan because the initial spread on the loan is increased. Rimsa may not expect interest rates to increase, so it will benefit from the conversion to a fixed-rate loan. Alternatively, Rimsa can hedge the interest rate risk with interest rate futures contracts or interest rate swaps. In general, savings institutions may be more capable than other non-financial firms in hedging their interest rate risk. c. If Rimsa maintains the mortgage on the office building purchased by Carson Company, who is the ultimate source of the money that was provided for the office building? If Rimsa sells the mortgage in the secondary market to a pension fund, who is the source that is essentially financing the office building? Why would a pension fund be willing to purchase this mortgage in the secondary markets? If Rimsa maintains the mortgage, its depositors provide the money. If Rimsa sells the mortgage to a pension fund, the fund’s employees and employers provided the money. The pension fund benefits from the mortgage because the mortgage generates interest and principal payments for its participants. Solution Manual for Financial Markets and Institutions Jeff Madura 9781133947875, 9781305257191, 9780538482172
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